In 1971, Congress enacted tax provisions providing special tax treatment for export sales made by an American manufacturer through a subsidiary that qualified as a "domestic international sales corporation" (DISC). Regarding research and development (R&D;) expenses, Treasury Regulation 26 CFR section 1.861-8(e)(3) provides what must be treated as a cost when calculating combined taxable income (CTI), and how those costs should be allocated among different products and apportioned between the DISC and its parent. Under this regulation, the Internal Revenue Service reallocated Boeing's company sponsored R&D; costs for 1979 to 1987, thereby decreasing the untaxed profits of its export subsidiaries and increasing its taxable profits on export sales. Subsequently, Boeing filed suit, arguing that it had an unqualified right to allocate its company sponsored R&D; expenses to specific products and to exclude any allocated R&D; from being treated as a cost of another product. In granting Boeing summary judgment, the District Court found section 1.861-8(e)(3) invalid due to a specific DISC regulation giving the taxpayer the right to group and allocate income and costs by product or product line. The Court of Appeals reversed.

Question

Was Boeing Co. required to take into account expenses incurred for R&D; in accordance with applicable Treasury regulations in calculating its "combined taxable income" for purposes of determining taxation with respect to its domestic international sales corporation and foreign sales corporation?

Yes. In a 7-2 opinion delivered by Justice John Paul Stevens, the Court held that section 1.861-8(e)(3) is a proper exercise of the Secretary of the Treasury's rulemaking authority. The Court reasoned that the general regulation classifying all R&D; as an indirect cost attributable to all export sales was not arbitrary as it provided consistent treatment for costs items used in computing domestic taxable income and combined taxable income. Justice Stevens wrote that the rule's "allocation of R&D; expenditures to all products in a category even when specifically intended to improve only one or a few of those products is no more tenuous than the allocation of a chief executive officer's salary to every product that a company sells even when he devotes virtually all of his time to the development of an Edsel." Justice Clarence Thomas filed a dissenting opinion, in which Justice Antonin Scalia joined.

Justice Stevens: We'll now hear argument in our first case, Number 1209, the Boeing Company against the United States.

Mr. Geller.

Mr. Geller: Thank you, Justice Stevens, and may it please the Court:

The Internal Revenue Code generally requires every corporation to pay an annual tax measured by its entire net income, but Congress decided 30 years ago in the DISC and FSC statutes that it wished to encourage exports by giving favorable tax treatment to the portion of a company's net income that's attributable to export sales.

In order to determine the extent of this income tax benefit, it's obviously critically important to determine precisely how much net income is generated by a company's export sales in any particular year.

In enacting the DISC statute, Congress said quite specifically how it expected this export net income calculation to be made.

Gross revenues from export sales were to be reduced only by those costs that were directly and factually related to the export income.

Export sales revenues were not to be burdened with unrelated expenses which would distort the true amount of export income, and thereby reduce the intended incentive.

The DISC regulations, which were promulgated shortly after the statute was passed, reiterate that there must be a direct factual relationship between export sales and expenses.

Justice Scalia: Where do you... do you get that proposition in the statute, Mr. Geller?

Mr. Geller: Justice Scalia, we get it out of two separate statutory provisions.

One is section 994.

Justice Scalia: Where are these to be found?

Mr. Geller: These are... this is found on page 27a of the appendix to the petition.

And specifically, the reference in 994(a) and 994(a)(2) to the requirement that a determination must be made of the net income, quote, attributable to export receipts.

We think that the common sense nature of the word attributable, which this Court in the tax context has construed to mean generated by, or caused by, is that you have to take the export... the revenues from exports and reduce them only by the costs or deductions that are related to those exports, or else you can't possibly come up with a true figure of export... net export income that's attributable to those... to those sales.

Justice Scalia: I... I suppose that... that R&D expenses have to be attributed in a lot of other instances under the code, don't they?

And... and doesn't the Government use this same procedure that it's been using here in other... in other areas where it has to attribute... where... where R&D expense has to be attributed?

Mr. Geller: Yes.

It relies on a provision, which we'll talk about in a few minutes, that has many, many applications, and it may well be that in a number of those other applications, it's perfectly valid.

Our position is--

Justice Scalia: Well, why is that?

I mean, why is it attributable--

Mr. Geller: --Well, as I hope to--

Justice Scalia: --okay elsewhere to... to produce this result, but not okay here to produce this result?

Mr. Geller: --Because it... the DISC provisions are unique in a number of respects, one of which it allows the taxpayer to engage in a particular grouping of transactions, and the... the... as we'll talk about in a few minutes, the R&D regulations insist that R&D be attributed in a way that disregards the particular groupings that the taxpayer has selected.

But there's another statutory provision that I'd like to call your attention to, Your Honor, and that's section 861.

861 is a section of the code that has been in the code, was in the code for more than 50 years at the time the DISC statute was passed, and it provides for how deductions are to be allocated to gross income.

This... this appears at page 26a of the appendix.

Now Congress, in passing the DISC statute, said quite specifically that it wanted deductions under the DISC statute to be allocated in a way generally in accordance with the principles of section 861, which were well-established at that time.

Justice Scalia: Where... where did Congress say that?

Mr. Geller: Congress said that in the reports of the House, of the tax-writing committee.

Justice Scalia: Just for my benefit, when it's in the statute, would you say Congress said it.

When it's in legislative history, would you tell me who said it?

Mr. Geller: Yes, Your Honor.

Justice Scalia: Because when you say Congress said it, I thought you mean it's in the statute.

Mr. Geller: Well, it's not in the statute.

It's in the reports of the tax-writing committees.

But, Your Honor, these were not idle statements.

These were not statements of individual Congressmen, or statements on the floor.

These were deliberate statements put in the reports of both the House and Senate tax-writing committees which focused specifically... specifically... on how Congress expected these deductions to be allocated.

And I would refer the Court to page--

Justice Scalia: And I'm sure everybody who voted for that knew about those statements.

Mr. Geller: --Your Honor, these were specific statements that went to the heart of the issue that's before the Court today, and we've quoted them at page 22 of our brief, the blue brief.

The committee reports said that... that the 861 rules, which are important because later the regulations themselves under DISC reference the 861 rules, so it's... and that's the heart of the Government's argument in this case, so it's important to understand what people thought at the time these 861 rules meant.

Justice Kennedy: But... but why does 861 get you out of the general allocation provisions any more than 994 does?

In other words, the question was, why do we ignore the usual rule for apportionment of R&D?

And you said, well, because 994 is... is specific and... and has some policies of its own.

And then you said... and to further that argument, you show us 861.

Mr. Geller: Yes.

Justice Kennedy: But the regs that we're talking about, which the Government relies on, are under 861.

Mr. Geller: Yes, but the... the regulation, Justice Kennedy, that the Government relies on was added to 861 after the DISC regulations were finalized.

It was added in 1977.

The DISC statute was passed in 1971.

The DISC regulations were finalized in 1975.

So our position is it's important to understand what Congress in 1971 thought it was doing in the DISC statute, and therefore it seems to us extremely important that it said that it expected deductions, including presumably any deduction, including R&D, to be allocated in accordance generally with the principles of section 861, which were described quite clearly in the Senate and House reports of the tax-writing committees to--

Justice Ginsburg: Mr. Geller, there's one problem.

Perhaps you can cast some light on it.

The word is attributable that you pointed to in 994.

And the R&D you have divided into Blue Sky and program or product-specific.

Mr. Geller: --Yes.

Justice Ginsburg: That... that's Boeing's creation.

The R&D... that division is eminently manipulable, it seems to me, if it... it's the distinction between whether it's allocated across the board because of Blue Sky or particular program or project depends on some official act by a corporate board which could be yesterday, could be next month.

It's in the control of the corporation.

Mr. Geller: Not... not quite, Justice Ginsburg.

It's not manipulable.

It has to satisfy the regulations promulgated under DISC.

The DISC regulations... and here I would refer the Court to page 33a of the appendix to the petition, and specifically the grouping regulations... provide that a taxpayer can only group... can only group transactions if they fall within a recognized industry product line.

So, in other words, you can't... you can't allocate expenses to any sorts of transactions you want.

They have to be grouped in a way that's consistent with the DISC statute.

And that's exactly what Boeing did here.

The Blue Sky R&D was attributable to all of their airplane products, and therefore it was allocated to the groupings of all of the different airplane programs.

These program-specific R&D... and I don't think there's any factual dispute about this.

The program-specific R&D was factually and directly related only to a specific program.

The 747 R&D, for example, was... was factually and directly related only to the 747 program.

And that's why Boeing allocated that R&D only to the 747 program.

Justice Stevens: Mr. Geller, can I ask you a factual question that will help me understand?

Does the... is there just one DISC involved here, or do you have several DISCs for different product lines?

Mr. Geller: No.

It's one... it's one DISC.

Justice Stevens: So that what difference would it make whether it was the 747 program, or the 727 program if the DISC sells them both anyway?

Mr. Geller: Because, Justice Stevens, under the statute, combined taxable income or export income is... is to be determined on the basis of product groupings, or at least, the taxpayer has the option of choosing to group by different products rather than by all the sales of the DISC.

So, therefore, here, we determine what the export income is for the 747 program, which takes the revenues from the 747 program and reduces them by the deductions, including R&D that's factually and directly related to the 747 program, and you... you come up with the CTI for the 747 program.

Under... it's not all mixed together as one group of export income.

Under... under the statute and regulations Boeing was entitled to group transactions.

The... the problem here is that the regulation that the Government relies on takes huge amounts of R&D that are directly related to a specific program and allocates them among all of the programs.

Justice Stevens: But, of course, the converse, I suppose under your view, all of the R&D would go to the domestic corporation because it all takes place before the product is put on the market.

Mr. Geller: No.

It doesn't really matter whether the product is on the market or not, Your Honor.

It has to be allocated to a class of gross income.

Now, that class of gross income may well include, as it does in this case, products or programs that aren't yet on the market that are being developed.

Justice Stevens: Right.

Mr. Geller: And nonetheless, the regulations are quite clear that the deductions have to be allocated to that class of gross income.

So, for example, in the 757 program, which was in... which was being developed in 1982, there were no sales of the 757 in 1982, and yet there were hundreds of millions of dollars of R&D expended in that year.

In our view, the regulations make it quite clear that Boeing had to allocate those deductions, that R&D and other deductions, to the 757 program.

Justice Souter: Well, what... what do you say to at least this argument of the Government?

I... I guess the Government would probably say, sure, there's... there's a kind of factual sense in which there is the kind of relationship that you're talking about.

But if you want the closest relationship... the most perfect relationship... you would capitalize your R&D and you would start amortizing it when you actually have a product that is generating income that you're selling.

That would be the closest match you could get.

That match, in effect, has... has been... has been set aside.

Instead of forcing you to do that, the law now allows you to... to use your R&D as... as a current expense.

Once you start using it, once you start treating it as a current expense, that very close relationship that you have, if you had capitalized it, is gone.

And what the Government is saying is, it's a judgment call how close it's got to be now, now that you have broken the link and have allowed current expense.

And that kind of a judgment call is quintessentially the judgment call that the... that the Treasury makes when it's write... when it writes regulations.

And why isn't that a pretty powerful argument?

And if it is, how do you get over the point of reasonableness or... or Chevron deference as the Government would see it?

But generally, just... as to the last point... this is not a legislative regulation.

There really is no Chevron deference that's in play here.

Justice Souter: Well, there's... there's... certainly there is some degree of deference here.

Mr. Geller: There is some degree of reasonableness.

Justice Souter: We can argue whether it's Chevron or not.

Justice Ginsburg: It was a notice and comment regulation.

Mr. Geller: It was, but it was promulgated under section 7805.

There's no specific provision in the code that allows the Treasury to issue legislative regs here, but I don't want to get off on that because it--

Justice Ginsburg: But you... if it's... whether you call it... if you call it an interpretive regulation--

Mr. Geller: --Yes.

Justice Ginsburg: --it still deserves some respect from a court--

Mr. Geller: Yes.

Justice Ginsburg: --does it not?

Mr. Geller: Yes, it does but it has to be consistent, obviously, with the legislative scheme that it's interpreting.

Justice Souter, let me answer your question a number of different ways.

First, it is not at all unique for expenses to give rise to future year income.

In fact, most expenses give rise to future year income.

The fact that an expense may occur in year 1, and the income may be generated in year 2, is a commonplace.

It doesn't in any way--

Justice Souter: Sure they do.

Mr. Geller: --It--

Justice Souter: But the most precise way to match it, I... I would suppose, is the capitalization way.

And the Government says once you... once you lose the quintessentially perfect way of doing it, then how you're going to recognize it is a judgment call.

Mr. Geller: --Well, I don't accept... they can't capitalize it, Your Honor, because Congress made a judgment in section 174 of the code in order to encourage R&D to allow it to be immediately deducted in the year in which it's incurred.

Justice Souter: Absolutely.

And they say when Congress made that judgment, there's a further judgment left and that is the judgment how close has it got to be.

Mr. Geller: Yes, but the Government's regulation here is not close at all.

The Government concedes that... that expenses for R&D give rise to future year income.

They can't... because of section 174, they can't--

Justice Souter: Well, sometimes... sometimes they do and sometimes they don't.

I mean, if things work out fine, the answer is yes.

If they don't work out fine, the answer is no.

And that's... that's one of the... that's one of the problems that the Government raises.

It doesn't make any attempt to match current year R&D expenses with some future income that might be generated from that R&D.

What it, instead, does, it allocates all of that income to current year expenses... to current year revenues for products that have no relation whatsoever to that R&D.

For example, let me say... come back again to the 757 program.

Justice Souter: Well, here... may... may I interrupt you with this question?

Mr. Geller: Sure.

Justice Souter: You say it has no relation whatsoever.

I take it then you are saying that the Government is simply factually wrong when it makes the statement that R&D, which may have a closer relation to one product line than another, nonetheless tends, as a general rule, to have benefits that go beyond product lines.

We... they... they, in effect, say, look, you learn useful things, and you use them all over the place.

For example, this case went off on cross motions for summary judgment.

There was really no dispute that Boeing had... as a factual matter... allocated the R&D expenses correctly.

As a factual matter.

The Government said they had to be reallocated because of this conclusive presumption in section 8(e)(3).

But, yes, I'm telling you, Justice... Justice Souter, that that's incorrect as a factual matter, that in fact, under section 174, in order to take a deduction for R&D at all in any circumstance, DISC or no DISC, the taxpayer has to be able to factually relate that R&D expense to a particular product.

Justice Souter: Oh, you've got to show the relationship--

Mr. Geller: Yes, factual relationship.

Justice Souter: --but it doesn't follow from that that there is no benefit to product lines outside of that relationship.

Mr. Geller: Yes, but if there... there could well be a spill-over benefit to future product lines, but that doesn't, A, mean that it's not directly and factually related a specific current program.

And also, look at the oddity and anomaly of the Government's position here, Justice Souter.

Even if it is... there is some spill-over effect for future product lines, when the Government... when the... when Boeing was developing the 757, it's conceivable that they were learning things that would benefit future products.

But what the Government does is take all that R&D and allocate it to existing products, sales of existing products that couldn't possibly have benefitted from that R&D.

Justice Breyer: That's so.

But could... I'd like very much to hear your response to Justice Kennedy's question.

Was it... and where we started was with Justice Scalia and Justice Kennedy.

And as I understand where they were driving, there is a statute, and the statute is DISC.

And under this statute, there's either some language, or there's some history anyway, which is of interest to me, which says when you work out the allocation rules, follow section 881... or 861.

Mr. Geller: 861.

Justice Breyer: 861, which is for allocation of all kinds of things--

Mr. Geller: Well--

Justice Breyer: --for Puerto Rico, to abroad, et cetera.

So now we look to 861.

Mr. Geller: --But--

Justice Breyer: And lo and behold, what they did in 861, after DISC was passed, is they changed the 861 rules, and in those changed rules, it says you're going to allocate everything to a SIC category called transportation services.

And then it has a little sentence here.

The taxpayer may not subdivide the categories in this list.

Mr. Geller: --Yes.

Justice Breyer: All right?

So that's their 861 rule.

Mr. Geller: That's... that is the--

Justice Breyer: All right.

Now, what legally is wrong with that--

Mr. Geller: --What's legally--

Justice Breyer: --since Congress told them to use 861, and here they're using it.

Mr. Geller: --Well... well, there are a number of things wrong with that, Justice Breyer.

The first is, as you yourself pointed out.

At the time Congress made this cross-reference, at the time the legislative history said that the rules under 861 would be followed, and at the time the regs were issued in 1975 that cross-referenced 861, this 8(e)(3) rule, which is an aberrational rule, doesn't follow the general guidelines of the 861 rules.

It was not even in the regulation.

Justice Breyer: That's right.

In respect to that, for you to win on that, we'd have to say that Congress intended that the rules be different for DISC's than for Puerto Rico, for Europe, for Saudi Arabia--

Mr. Geller: Oh, absolutely.

Absolutely.

Justice Breyer: --for everything.

Or we'd have to say that we're throwing out this reg for everything.

Mr. Geller: No, no, no.

The reg has many other applications, and we're not suggesting that it be--

It is critically important to have an accurate calculation of what the export net income is.

You cannot have an accurate calculation of the net income from sales of 747s if you're going to start with the gross revenues from the sale of 747s, and then you're going to deduct from it expenses that have no factual relationship to 747s.

You inevitably are going to be left with an erroneous net income calculation.

Now, I want to also add that this was focused on in 1973 and 1975 when the Treasury was issuing its DISC regulations.

In 1973, Treasury issued proposed regulations under 861 that specifically said how R&D was going to be... was going to be allocated in the context of a DISC.

They gave an example, which is identical to the example of this case.

It was an example involving a manufacturer that manufactured four, six, and eight-cylinder engines.

Each was grouped as a separate product line, as it was entitled to be--

Justice Breyer: I'll assume the example was identical.

Mr. Geller: --It is identical.

Justice Breyer: And I will take your words that you have just said.

Mr. Geller: Yes.

Justice Breyer: And I will ask you why a different person quoting those words couldn't make the identical argument in respect to the tremendous tax advantages given to Puerto Rico--

Mr. Geller: Because--

Justice Breyer: --or in respect to the supreme importance of having allocation between Europe and the United States among subsidiaries--

Mr. Geller: --You'd have to look... you'd have to look--

Justice Breyer: --and principal corporations be accurate.

Mr. Geller: --You'd have to look at those statutes.

It may well be that 8(e)(3) couldn't be applied there at all if it would lead inevitably to an incorrect calculation of... of that net income.

But there's something in addition here, Your Honor.

Two things in addition.

First, Justice Breyer, the 994 regulations do not incorporate verbatim all of these 861 rules.

They don't incorporate 8(e)(3).

They don't incorporate... they say that the allocations to be made under section 994 are to be done generally in accordance with the rules under 861.

At the time that that was put in the regulations, the rules under 861 unequivocally provided that there had to be, for every allocation, a direct factual relationship between the expenditure--

Justice Scalia: Yes, but that doesn't mean when... you say in accordance with 861.

Does... does that mean as it now exists, or--

Mr. Geller: --Yes.

Justice Scalia: --861 as it may be amended from... or, you know--

Mr. Geller: I--

Justice Scalia: --as it may be interpreted from time to time by... by--

Mr. Geller: --Not... not--

Justice Scalia: --by Treasury?

Mr. Geller: --I believe, Justice Scalia, not if an aberrational... not if a rule could be put in several years later that's inconsistent with the rules that the tax-writing committees and that the Treasury Department assumed--

Justice Scalia: But that--

Mr. Geller: --would be the 861 rules.

Justice Scalia: --That's a different argument.

That--

Mr. Geller: That excepts--

Justice Scalia: --What I'm saying is it doesn't seem to me, even if you believed in... in legislative history, you can't rely on the fact that they say it's going to be done pursuant to 861.

The Government says, we are doing it pursuant to 861.

Mr. Geller: --But not pursuant to the rules.

This is... if you look, in fact, at the 8(e)(3) regulation, Justice Scalia, it begins by explaining why it's deviating from the general rules of 861, why it felt the need for R&D to deviate from the general rules that require a factual connection between expenditures and revenues.

Now, there's another... there's--

Justice Kennedy: If you... if you want me to say that a regulation drawn after a statute was enacted, another statute, is... is invalid because the intervening statute is... is applicable instead, what... what case do I cite, or what rule?

Is... is the rule just that the specific controls over the general?

I mean, is that all we're talking about?

Mr. Geller: --It is.

It is certainly the specific controls over the general.

It is also the fact that there was a regime here that requires a... accurate calculation of export income.

The rules that were promulgated in 1975 did that.

An aberrational rule was put in in 1977 which we say is inconsistent with the accurate calculation of net income and can't be applied, at least in this context.

But there's another reason, Justice Kennedy, why the 1977 8(e)(3) regulation is inconsistent with DISC, and that's the grouping regulations, which I want to call your attention to, which is a very, very important part of the DISC statute.

If I could call the Court's attention to the grouping regulations which appear at... at 994(c)(7), which is the bottom of page 33a of the appendix to the petition, you will see that the... the taxpayer was entitled to group its products, to figure out export income not in gross, but on the basis of each product or recognized product line, which is what Boeing did here.

And if the Court would look at (6)(iv) in the middle of page 33a, you'll see that the regulations provide that the taxpayer's choice as to how to group is controlling... controlling.

And the regulations go on to say that costs deductible in a particular year shall be allocated and apportioned to the classes of gross income resulting from such grouping.

Justice Kennedy: Now... now, perhaps you can help me here because this is a complicated statute.

Is the Government going to answer that, of... of course, that is... is controlling, but that is only for the purpose of one of the three... of... of one of the three choices that it makes in... and... and it's made the choice to have the combined income?

Mr. Geller: Yes, that's the Government's argument.

But it's completely inconsistent with the words of the regulations, Justice Kennedy.

The regulations say that all of the determinations under (c) have to be made consistent with the grouping, including the allocation of deductions.

So--

Justice Kennedy: And where... where does it say that?

Mr. Geller: --It says it in the language that I just read to you, that the... all... that the costs deductible in a taxable year shall be allocated to the items of gross income resulting from such grouping.

First, the language of the statute... it's critical to determine an accurate calculation of export net income.

The 8(e)(3) regulation provides conclusive presumptions in place of factual matching so that it inevitably will lead to an incorrect... and secondly, as I said, the... it was the understanding of everyone, including the Treasury Department when it issued the DISC regulations in 1975, that the taxpayer's choice of grouping would be controlling, that... that allocations of deductions, including R&D deductions, would be... be made on the... on the basis of the taxpayer's grouping.

And when 8(e)(3) comes in, it says, no, no, no.

For R&D--

Justice Stevens: Mr. Geller, on that point doesn't the word grouping, the last word in subparagraph (iv), refer to the three choices in subparagraph (vi) of the... on... on page 32a?

Mr. Geller: --No, no, no.

I think it refers to the... to the choices that are to be made in paragraph (vii) at the bottom of page 33a, and the top of 34a.

The groupings are... you can... you can determine CTI, Justice Stevens, either on the basis of each individual transaction, which would be very, very cumbersome.

Congress understood that and therefore expected that there would be grouping.

The taxpayer is entitled to choose two different ways to group its transactions.

One is by recognized product line... which is what Boeing did here, the 747s, the 767s, the recognized product lines... or basis of SIC code.

Boeing could have chosen to group its transactions by SIC code.

It chose not to do that.

And nonetheless, the 8(e)(3) regulation comes in and insists that although all other deductions can be made on the basis of the product groupings chosen by Boeing, which the regulations say are to be controlling, this one class of deductions, R&D, has to be allocated on the basis of SIC code.

And that's completely inconsistent with the statement in the middle of page 33a that we were talking about that says that all of the deductions are to be allocated on the basis of the taxpayer's grouping, and that that grouping is, in the words of the regulation, controlling.

Justice Scalia: But... but the Government is going to come back and say, look it, if you did it transaction-by-transaction, we would apply our normal rule under 861.

Mr. Geller: If you did a--

Justice Scalia: You say it's a lot different.

Mr. Geller: --I think the... actually--

Justice Scalia: Would that be correct if they did--

Mr. Geller: --No, no.

It would actually help our argument.

If you did it transaction-by-transaction, you took an individual sale of a 747--

Justice Scalia: --Right.

Mr. Geller: --airplane and you tried to figure out what the export net income was from that sale, it seems to me you would start with the cost of the... of the revenues generated by the sale of that single airplane, and then you would try to figure out what costs were incurred in producing that airplane, including the R&D costs.

You would never, I think, take costs that were incurred that year in trying to develop a 787 airplane, which had no relationship whatsoever to the sale of that 747, and attribute those costs to it in order to reduce the net income.

That's what the 8(e)(3) regulation does.

If the Court has no further questions, I'd like to reserve the balance of my time for rebuttal.

Thank you.

Justice Stevens: Mr. Jones.

Argument of Kent L. Jones

Mr. Jones: Thank you, Justice Stevens, and may it--

Justice Scalia: Mr. Jones, before I lose the thread of... my thread of thought, is it correct what Mr. Geller just said, that if it was done transaction-by-transaction, you would not use the same... the same allocation basis that you're using here?

Mr. Jones: --No.

If it were done on a transactional basis, which is the... the base case provision under DISC, 861 regs would tell us how to allocate costs to the income from that transaction.

And what... I mean, really the... the first point of departure that Mr. Geller made from the statute is that he suggests that only costs... or that any... the costs must be factually related to an item of income to be set off against it.

But that's not the statutory standard.

Justice O'Connor: Well, this is kind of simplistic, but it does seem that in... in the 1970s, Congress wanted to encourage exports, and to do that, they thought they should make some income tax advantages for companies producing products for export.

And that involved allowing grouping of products and favorable income tax treatment which, if you didn't have the... the 861 regulations on R&D, would allow the taxpayer to do what the petitioner is arguing here.

So, it seems to me the argument is that the 861 regs are just so contrary to DISC that they shouldn't govern and don't govern.

Is that the thrust of it?

Mr. Jones: Oh, clearly that's not the case.

The 861 regs were... were formulated for the purpose of determining combined taxable income for DISCs and FSCs.

That's what Congress... that's what the committee said they wanted the Secretary to do under the DISC, and that's what the 861... if you look at 861(f)(1)(iii), it says that expressly.

So--

Justice O'Connor: But 861 applies generally, doesn't it, not just to DISCs?

Mr. Jones: --It... it applies generally, but it was specifically formulated with the calculation of combined taxable income for DISC in mind.

And so it's... it's illogical to suggest, as... as they do--

Justice Scalia: The statute was, or the reg--

Justice Kennedy: --You mean the reg?

Mr. Jones: --I'm sorry.

I meant the reg.

The 861-8 reg was... was formulated with the calculation of combined taxable income expressly in mind, and we know that both by the terms of the reg 861-8(f)--

Justice O'Connor: Well, how do we know that?

Justice Kennedy: Getting back to Justice Scalia's question, and I think it relates to what Justice O'Connor is asking too, is... is your answer to the last argument, that a transaction-by-transaction basis... we would... would clearly not have this problem... is we clearly would have this problem and we'd look at 861, and you'd lose there too?

Or is that not your answer?

Mr. Jones: --Well, that's one way of making the point, but let me... let me address directly--

Justice Kennedy: No, no.

I want to know what your position is.

Mr. Jones: --Well, my position is they've totally misdescribed the grouping provision of the DISC regs, and once you understand it, you will appreciate that the 861-8 regs apply to all of these transactions.

And you can... you can see that by looking at only two pieces of the DISC regs.

The DISC regs, at page 29a in the middle of the page, says, grouping of transactions for purposes of applying the pricing method is provided by (c)(7).

So, you group to decide what your pricing method is, and if they choose the... the combined taxable income method, which they've done here, then you go to (c)(6), which is back on page 33a.

(c)(6) says here's how you determine combined taxable income.

You take the income.

You deduct the costs of goods sold, and then you allocate under provisions of... of section 861 regs.

And then the provision that Mr. Geller cites says... is the (iv) provision, which says you that allocate the costs to the items of income resulting from the group.

That's what the grouping does.

It groups the income, and then against that income, we apply the costs allocated under the section 861-8 regs.

Mr. Jones: It's the last phrase of the... of the item (iv), and it says that we allocate costs to the income resulting from the grouping.

Now, that's what the grouping is all about.

They're allowed to pick out a series of transactions, group the income, calculate the CTI for the group, so they don't have to file a separate report for a thousand different transactions.

That's all that the grouping is about.

Now, that's been the Secretary's interpretation of his own regulations for 25 years.

And of course, under this Court's precedents, his interpretation of his own regulations is entitled to controlling weight unless it's inconsistent with the provisions of the text of the regs.

And as the Tax Court explained in the St. Jude case, and as I have just described, the text of the reg says you allocate under 861 to the income resulting from the grouping.

Justice Breyer: All right, that's fine.

But he says that... and what you're supposed to do is you're supposed to, I guess, subtract the costs which are allocated to the items of gross income in that group.

Is that what you're supposed to do?

You take the gross receipts in that group--

Mr. Jones: You take the gross receipts for that group--

Justice Breyer: --and you subtract the costs.

Mr. Jones: --and then you allocate costs--

Justice Breyer: Yes.

Mr. Jones: --under 861.

Justice Breyer: Right.

Now, you allocate them under 861.

Mr. Jones: Right.

Justice Breyer: So we go to 861--

Mr. Jones: Right.

Justice Breyer: --and he says, now, if you look at 861, and try to allocate according to 861 to the group that they've picked out, it's seriously nuts, basically.

I mean, imagine that you had a farmer and the farmer raised roses, and he had some fishes, and... and what he has is he does research on fish diseases.

And he says... you'd say, well, my goodness, you're going to allocate his whole laboratory costs which does nothing but fish diseases to the growing of roses because both are farming or fisheries.

Now, is it... something like that is really out of whack, it makes so little sense that that isn't a reasonable method of allocation under anybody's theory.

Mr. Jones: That's... that's a fair synopsis of their position, and... and the defects in it--

Justice Breyer: Right.

So why is it reasonable to allocate the fish disease research to rose culture?

Mr. Jones: --Well, let me start with what the Secretary was supposed to do in the regs, and get to you the answer to your question.

The... the statute on which the regs are adopted doesn't just say you allocate the costs that are definitely related to the product in determining what costs would be charged against it.

It also says you allocate to it a share of costs that cannot definitely be allocated to any particular item of income.

Now, when the conundrum for research costs... and the reason that we have a separate regulation for it is that there's more than one way that research costs are treated under the code.

When research costs are capitalized and amortized over their useful life, they're then properly attributed... as this Court said in INDOPCO... to the revenues as they're received.

But when the taxpayer makes the election that section 174 gives it to take a current deduction, it severs any relationship between the costs and the income.

There is a mismatching, as we say.

There is no proper connection between the costs and the income.

Now, the reason that we need to... the... the... in that case where there is no definite relationship between the costs and the income, the default principle of the statute is that the costs are to be allocated over all income of the taxpayer, not just the income from any specific product, but the income from--

Justice Breyer: He'll grant you all that.

He grants that.

Mr. Jones: --No--

Justice Breyer: But he says, you know, sometimes it is clear.

For example, it is clear that roses don't get fish diseases, and similarly, he says, it is equally clear that... I don't know the factual details, but he says it's equally clear that a 727 research is not as vague as a... is... is different from a 757.

Just the same... roses and fish diseases.

And he says where it's that clear, it's not reasonable for the Treasury to try to pretend that it's vague or hard to allocate, et cetera.

Mr. Jones: --The... a reason why the regulation is reasonable is because if, as I have just said, the statutory default cases... you can apply it against all income.

What the Secretary has said is, well, I'm not going to make you apply it against all income.

I'm going to make you apply it only against a subcategory of income, in this case, the income associated with sales of a product from which foreign sales income might be derived.

Justice Kennedy: Yes, but you use this link... this severance argument, and you say, oh, well, once you do this, you sever the expense from the future income.

I would have thought... please correct me if I'm wrong... that all expenses are... are severed in the sense that all expenses can be used for future income.

Mr. Jones: No.

That's a... that's a fallacy in... in the suggestion of Mr. Geller that mismatching occurs all the time.

It's very rare for mismatching to be tolerated.

For example, if a taxpayer spends $10 building a widget in year 1, and sells the widget in year 2, the $10 he spent in year 1 isn't mismatched.

It's put in the inventory costs.

It's charged as a component of the costs of goods sold in year 2, when the item is sold.

The code is... and the Secretary is very thorough about routinely requiring matching of expenses.

This is an exceptional situation created by the Congress allowing the current deduction, but as Justice Souter pointed out, allowing the current deduction for research doesn't mean that that's... that Congress decided it was definitely related when it was taken.

It clearly isn't definitely related.

And so my... my point was that if it would have been reasonable for the Secretary to just do what the statute says, which is we'll apply it against all income, it's more reasonable, the Secretary decided, to apply it against a smaller category.

And then... and then 5 or 7 years later, the Secretary decided it was even more reasonable to... to apply it against a somewhat narrower category, and we got down to SIC code 3.

Well, these are all alternatives, each of which is reasonable.

They're more reasonable than the statutory default case, the Secretary decided.

Justice Ginsburg: Under code 3, would there be any difference?

It was still transportation equipment as a category.

Mr. Jones: For Boeing, we can go all the way to SIC code category 4, which is planes and parts.

I mean, this... this issue is sort of abstract in this case because whatever, you know, objective test the Secretary had used, it would result in the same in... in this case.

Justice Breyer: Where does the statute say you could just apply it across the board?

By... the statute in 994 that I have just refers to 50 percent of the combined taxable income, and that doesn't define--

Mr. Jones: I'm talking about section 861, which is at page 26a of the petition appendix.

Justice Breyer: --26a, yes.

Mr. Jones: And subpart... part (b) in the middle says that you allocate a ratable part.

It says par, but I think that's ratable part of expenses which cannot definitely be allocated to some item or class of gross income.

So you... and you... you would under the default case make that allocation across all items of income.

Justice Scalia: Well, his argument is that it can... that... that the research on fish can definitely be allocated to fish.

Mr. Jones: If... if it's currently deducted, it cannot be definitely allocated to an item of income.

You see, petitioner just takes two words out of the statute and changes them.

The statute says you allocate costs that cannot be definitely allocated to an item of income.

And he says, well, we allocate costs that are factually related to a product.

Well, that's not what the statute either says, or is about.

We allocate costs to income not to products.

Now, the--

Justice Scalia: It says item or class of gross income.

Mr. Jones: --Right.

Justice Scalia: What is... what is class of gross income?

Mr. Jones: Well, for example, if they group products, they... they group all the sales of Boeing 707s.

Then you allocate the costs to that group based on the costs that can be directly allocated.

Justice Scalia: For that year.

Mr. Jones: --and they share--

Justice Scalia: You're saying it has to be that year.

Mr. Jones: --Yes, and a share of the costs that cannot be directly allocated to an item... to any item of income.

Now, this... the reasonableness of this... of the Secretary's approach is especially clear in light of the alternatives that he faced.

If he had adopted the... the position that petitioner prefers, the result would be that petitioner would claim an expense against a product that was going to be built and sold some other time, and never charge that expense against that product when it's sold.

Now, the obvious and unimpeachable result of that is they overstate their foreign sales income.

And in this case, they do it by $2 billion over the period that's at stake.

They overstate their foreign source income, which has the direct consequence of overstating the... the DISC and FSC benefits that they calculate based on that amount of combined taxable income.

Justice Stevens: But isn't it true, just going back to Justice O'Connor's thought, that... that the consequence... the Government's position is that all research and development cost gets allocated to the DISC when you're in a business like they are?

Mr. Jones: I think that's... I don't understand the factual context of that statement, but the... the answer is all research costs, like every other type of cost gets charged against the income... against foreign sales income to the extent that--

Justice Scalia: Proportionately.

Mr. Jones: --Proportionally, yes, thank you.

Pro rata if it's not current... you know, if it's currently claimed and not capitalized and amortized.

If it's capitalized and amortized... I should just point out because it's... it is a factual point that is worth knowing.

If it's capitalized and amortized, then the costs are recovered as part of the cost of goods sold--

Justice Stevens: No.

I... I understand the distinction between capitalizing it and... and taking it in the current year.

But it seems to me that... that the... the net result of the Government's approach is that... that all of the... all of the research and development expense of the company would be attributable to the DISC.

Mr. Jones: --It would just be attributable to the... to... well, I mean--

Justice Scalia: If... if the DISC is 25 percent of its sales--

Mr. Jones: --If all--

Justice Scalia: --25 percent of its R&D--

Mr. Jones: --Correct.

If all the sales were DISC sales, then... then you would be right.

But if... if some portion of the sales were domestic, which is certainly the case with Boeing, then that portion would be allocated to that portion of the income.

I mean, this pro rata allocation that I've been talking about, that what you're allocating between is the sales that the DISC makes and the sales that the DISC doesn't make.

Justice Souter: --What are the... just out of curiosity, what are the rough proportions of... of overseas and domestic sales?

Mr. Jones: I believe the record says something like two-thirds of Boeing's sales during this whole 10-year period were overseas and, therefore, I assume, made through the DISC.

Justice Kennedy: But just as a housekeeping matter, if Boeing were to prevail here, would it still be open for the Government to say, well, all right, you can allocate along your product lines, but the Blue Sky portion still has to be greatly increased?

Mr. Jones: You mean, would it be open at this stage--

Justice Kennedy: I think I've got the right color.

The Red Sky and the Blue Sky.

The Blue Sky is the general.

Correct?

Mr. Jones: --Yes.

At this stage of--

Justice Kennedy: And that was about some 20 percent.

If... if the... if Boeing prevails, can you still go back and say, okay, you get the product line, but you've got to add another 20, 30 percent to the Blue Sky?

Mr. Jones: --I hate to make a concession that I'm not 100 percent certain... certain about, but... especially since, you know, it... it could be of importance.

I do not believe that issue is open, but it... but if it were, I would reserve our right to address that.

But I don't... I don't know exactly how it would be open.

Justice Ginsburg: Mr. Jones, I thought... maybe I'm confused, but I thought the Government's position was Blue Sky, product-specific... this is R&D and we treat R&D a certain way and we don't buy into that line, which is set by the company.

Mr. Jones: Oh, I agree completely, but... but I understood Justice Kennedy to be saying that if the Court adopted Boeing's approach, would there then be a factual question about what part... whether the Blue Sky amount was accurately described in the record.

And I just don't know for certain.

My assumption is that that's not still open.

Justice Breyer: Is... is it open as to... suppose the... you were to say the following.

Where a taxpayer can show that a particular R&D expense can be definitely allocated to some item or class of gross income, other than the DISC class in this situation or whatever, where they can show that, then the commissioner cannot require them to allocate it to a different item.

Mr. Jones: Well, it... I--

Justice Breyer: That would be just taking the words of the statute.

Now, suppose you said that.

Mr. Jones: --It sounds... it sounds like you correctly described the statute, and let me point out that if they, for example, did their fish research or whatever it was--

Justice Breyer: Yes.

Mr. Jones: --and they capitalized and amortized it to the... to the appropriate products and charged it, then... then they would be entitled to--

Justice Breyer: So... so that's what... that's what I find difficult to reconcile with the 861... 861-8... what is it called?

It's 861-8--

Mr. Jones: --(e)--

Justice Breyer: --(3)--

Mr. Jones: --(3)(i).

Justice Breyer: --et cetera... sentence which says but you have to use two-digit SIC categories because I think they're so broad, those categories, that it should be possible, like my fish example, to find instances where you could.

And why aren't they in that category?

Mr. Jones: First, it only... that only applies if they're deducted under 174.

So... so we've narrowed the issue that much.

And when they're deducted under 174, as I've said, there were a series of reasonable alternatives facing the Secretary based from the statutory default case that you allocated across all income.

Now, the reason I keep stressing that point is because this Court's decisions are very clear that the Court, especially in the context of Treasury regulations, doesn't sit here to decide the wisdom of the particular rule chosen.

It only... in the words of Correll... looks to see whether some reasonable method was applied, not whether this was the best one, or the most logical--

Justice Kennedy: Yes, but it seems to me that what you're doing is... is quarreling with the decision Congress made under 174.

Congress said R&D is inherently something that ought to be capitalized, but we think it's so important, it's going to be expensed.

And you keep saying that, well, you know, really it can't be expensed.

We're going to, in effect, make them capitalize it anyway.

That... that's--

Mr. Jones: --No.

We're... we're not making them capitalize it.

I mean, I would cite, really, my explanation of that as Justice Souter's question earlier, that... which is that the... the decision to allow this current deduction is effective in determining taxable income for domestic purposes.

We don't dispute that there's a deduction, but I'll point out 861... the mere fact there's a deduction doesn't tell you how to allocate it.

And the... 861 says that if the deduction is not definitely related to some item of income, then you charge it against all the items of income.

Justice Scalia: --Can... can I come back to the Blue Sky expenses?

A question that was asked earlier caused me to question my understanding of the case.

As I understand it, Boeing is willing to accept a ratable portion of the Blue... Blue Sky expenses in its DISC.

Right?

Mr. Jones: Yes.

They actually want to--

Justice Scalia: Just a... what it... what it's objecting to is... is those expenses that... you know, that... that go to fish research, those expenses that are identifiable to a particular category.

Mr. Jones: --Just to elaborate, that go to fish research that that... that were deducted currently rather than amortized over the proper future income.

That's... that's what this case is really all about is this peculiarity--

Justice O'Connor: But that's the whole scheme that Congress passed in the '70s to try to encourage exports.

So it just... the interpretation of 861 in the regs seems to go somewhat contrary to the overall purpose of the scheme for DISCs.

Mr. Jones: --Several... several courts have correctly said that the purpose of the... of the combined taxable income calculation is to serve as a limit on the DISC and FSC benefits.

Congress didn't intend unlimited benefits.

They didn't intend to allow benefits of the type that Boeing is seeking where they inflate their foreign source income by not... not putting the costs against that income in calculating it.

And so, the answer to your question is no.

The Secretary's rule is designed to accomplish the correct, in the Secretary's view, determination of combined taxable income for this very purpose.

Now, it... I think that... that the issue that... that may actually be the one the Court wants to consider first is that in 1984, when Congress enacted the FSC provision, it... it in our view ratified and adopted the very cost... research cost allocation regulation that we have in this case.

In... in the Deficit Reduction Act of 1984, there are two provisions that relate to this case.

Congress adopted... enacted the FSC which, of course, is based on the provisions of the DISC, and... and it also contains the combined taxable income method of limiting the... the benefit.

And... and at the same time that they adopted the FSC, they enacted a provision that took one piece of this regulation out and suspended it.

That's the piece called geographic sourcing.

That, for purposes of citation, is 1.861-8(e)(3)(ii).

This case is about 1.861-8(e)(3)(i), which is the rule that calculates combined taxable income.

And when Congress took out... said we're going to suspend this geographic sourcing rule in this regulation, they said, we're not suspending this regulation for application in calculating combined taxable income for DISCs and FSCs.

Well, under this Court's decision in Lorillard v. Pons, that is a ratification and adoption of the regulation.

The Court made the point in Lorillard that when a--

Justice Stevens: Mr. Jones, can I go back for just a second... and be sure I understand something right... to the fish/roses hypothetical?

Am I correct in assuming that the fishes... the research on the fishes would be charged to the DISC only if fishes and roses were in the same SIC grouping?

Mr. Jones: --Under any scenario, that's correct.

Justice Stevens: Oh.

So if they're in a different grouping, then the rose farmer wouldn't have to pay for the fish research.

Mr. Jones: That's correct.

I was assuming you carefully constructed your question.

Justice Scalia: But the... but the grouping can be as broad as... as transportation equipment.

Mr. Jones: It can be quite broad.

Justice Scalia: That's a pretty broad group.

Mr. Jones: It can be quite broad.

But the point is that it's not--

Justice Breyer: And it includes, by the way, agriculture, forestry, and fisheries.

That's one category.

Unknown Speaker: [Laughter]

Mr. Jones: --It's not... it's... the point is it's not as broad as the statutory default rule.

The statutory default rule is by definition reasonable, and the... the narrower rule that the... that the--

Justice Scalia: You've lost me.

The statutory default rule--

Mr. Jones: --Is that you apply these costs against all items of income because they're not definitely related to an item of income.

That's the statutory default principle.

Justice Scalia: --Where is that?

Mr. Jones: That's in 861(b) at page 26a of the petition appendix.

It says that--

Justice Scalia: Got you.

Mr. Jones: --Okay.

Now, on the ratification point, Lorillard v. Pons makes the point that when Congress enacts a statute that's based upon a... a prior... the provisions of a prior act, it is assumed to have adopted the... the administrative interpretation.

Now, that's not a... by itself an overpowering presumption, but what Lorillard pointed out was that when Congress, in doing that, looks at the agency's interpretation and excised a portion of it, the inference that it approved the remaining part is very strong.

Now, here, it's strong not only because of that inference, but because Congress said... I'm sorry... the committee that made this amendment said that they... although they were excising this part about geographic sourcing, that the part about combined taxable income calculations for DISCs and FSCs would remain in effect.

Now, petitioner says, but 2 years later Congress did something that somehow negated that ratification.

Well, of course, the sub... Congress can't change the law as ratified, but that's not what happened in '86 in any event.

What happened in '86 was that the... the committee what was... that was removing the suspension of the... on the geographic sourcing rule said that we're not saying whether the regulation is valid or not.

Well, the regulation that they were talking about was the geographic sourcing rule.

Petitioner says, well, they were talking about the whole rule.

No.

They were talking about the geographic sourcing rule as we know from the last part of that same report which says that nothing in this act has anything to do with the use of these... of the... of the research cost allocation regulations for calculating CTI... combined taxable income... for DISC and FSC purposes.

Justice Kennedy: Correct me if I'm wrong.

In the court of appeals opinion... and it's the paragraph at 12(a).

I think you'll be familiar with this one, where the court of appeals said, the more narrowly a taxpayer chooses to define incomes, the more costs become indirectly or indefinitely related.

Can I be excused from trying to understand that, or--

Unknown Speaker: [Laughter]

Mr. Jones: Well, I can try to help, but I'm... I can't promise results.

It... it looked to me like what they had in mind was the thought that this... that a taxpayer who says my research only relates to wing nuts on... on this plane is... is defining it so narrowly that it's not realistic.

And... and indeed, the record of this case reflects that... that research on one type of plane has applications on other types of planes.

And... and I think what the court was addressing there was his view that... that this was an appropriate accommodation.

This was one of the choices that the Secretary had.

It was a reasonable choice.

Justice Kennedy: It really was restating the problem rather than offering a specific solution.

Mr. Jones: I think it was restating the problem in a way that indicated it felt that the Secretary's choice was a reasonable one.

Justice Ginsburg: Mr. Jones, can you tell us this continuing significance of this arrangement?

I... we're now past the successor of the FSC.

Is that true?

Mr. Jones: Yes.

The FSC is no longer with us.

It was replaced by the extraterritorial income provisions... maybe in '98.

I'm not sure.

Justice Breyer: What about the two-digit SIC?

Is that still with--

Mr. Jones: Two-digit is... it was replaced by the... the narrower three-digit band in '94, I believe.

Justice Breyer: --So if we thought the two-digit was a little bit going too far, would that throw open all kinds of claims on the... on the... from all kinds of people?

Mr. Jones: Well, I mean, again, if the Court wanted... felt it needed to look at the two-digit versus three-digit, although to me they're just, you know, spectrums along the--

Justice Breyer: The degree of specificity... well, at least three-digit would separate the roses from the fish.

Mr. Jones: --This case really doesn't present the question--

Justice Breyer: It doesn't.

Mr. Jones: --because, as I said, there's just... is... there's no question that Boeing goes all the way to SIC 4.

And so if the standard is are the products reasonably related, which... which is--

Justice Breyer: So we don't have to consider it.

All we'd have to--

Mr. Jones: --I don't think you have to consider it, but if you did, I think you would do it in the context of realizing these are reasonable alternatives, and that the Secretary didn't have to pick the best one.

He just had to pick one of them.

And I... if you thought that none of these were reasonable, then... then, you know, it wouldn't matter which one he picked.

Justice Breyer: --At some point they certainly--

Mr. Jones: If there are no further questions, thank you.

Justice Stevens: --Thank you, Mr. Jones.

Mr. Geller, you have a little over 2 minutes left.

Rebuttal of Kenneth S. Geller

Mr. Geller: So much to say.

Justice Kennedy, I think you put your heart on the... on the Government's... the... the problem with the Government's position here.

It's simply an unwillingness to accept the fact that Congress created a number of incentives here that were not designed simply to raise revenue.

They had other purposes such as the export... the... the beneficial treatment of export income and also the immediate deductibility of... of R&D.

Now, the Government tries to defend this regulation here on the... on the basis that there's this temporal mismatch and it's all the result of not capitalizing.

I should say a number of things about that.

First, this was not the basis for the regulation at the time the regulation was issued.

It was not the basis for defending this regulation in the lower courts.

And it... and the Government's position is not even consistent with that regulation because if the whole problem here is the lack of a temporal mismatch, you would think that if you had a class of gross income in which in a particular year there was both revenues and R&D expenses, well, in that situation there's no temporal mismatch.

They would at least allow you to allocate those R&D expenses to that revenue in that year.

No.

Even if there's revenue in a class of gross income in a particular year, they still insist that those R&D expenses be spread across all of the income in that SIC code.

Now, I want to mention St. Jude, because in this case we're dealing with airplanes and airplanes, and while the... the costs are specifically allocated only to particular programs, it gets a little more complicated.

But look at St. Jude.

In St. Jude, you had a manufacturer who was exporting artificial heart valves.

That's all it was doing, is manufacturing and exporting artificial heart valves.

In the same year, it was engaging in R&D for insulin pumps, and for pacemakers.

The Government insisted that the export income from the sale of those heart valves be reduced, and that the DISC benefit be reduced because of the R&D spent on these other products that obviously had no basis or relevance to the sale of the heart valve simply because they were all within the broad... same broad SIC code.

And I should say, Justice Kennedy, the Ninth Circuit's opinion I think is somewhat unintelligible.

The... the part that you... you referred to, we all stumbled over because it makes no sense.

The more narrowly... the more narrowly you define your classes of gross income, the more that... that costs will be directly allocated to more than one class of income.

It's not a question of anything being indirectly allocated.

And there's no default rule at issue here either because all of our costs are directly allocable to specific programs.

Mr. Jones: The opinions of the Court in two cases will be announced by Justice Stevens.

Argument of Justice Stevens

Mr. Stevens: The first case is 01-1209 Boeing Company against the United States.

In 1971 and again in 1984, Congress enacted statutes that provide tax incentives for American manufacturers to increase their export sales.

Because both statutes provide for a lesser tax burden on qualifying subsidiaries that handle exports, it is advantageous for the parent to minimize its share and maximize the subsidiary share of the aggregate income produced by export sales.

The statutes, however contain rather complex provisions limiting the amount of the aggregate taxable income that maybe assigned to the subsidiary.

This case involves the dispute over the method used by Boeing to allocate several billion dollars of research and development cost between the parent and its export subsidiaries.

The rules for allocating such cost are not set forth in the statutes but are covered by Treasury Department Regulations.

In its challenge to the Government's computation of its taxes for the years 1979 through 1987, Boeing contends that the Government has misinterpreted one regulation and improperly relied on another.

The District Court, following a decision by the Court of Appeals for the Eight Circuit, agreed with Boeing, but the Court of Appeals for the Ninth Circuit reversed.

We granted certiorari to resolve the conflict.

Despite the fine argument advanced by counsel, for Boeing for reason stated in an opinion filed with the Clerk, we affirm the judgment of the Ninth Circuit.

Justice Thomas has filed a dissenting opinion that is joined by Justice Scalia.